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Tax Breaks Ease the Pain Of Investment Losses

No one likes losing money on an investment, but tax laws offer some relief. Taxpayers who realized investment losses during 2009 can use them to offset capital gains, reducing their tax bill. Plus, they can use losses that exceed capital gains to wipe out up to $3,000 of ordinary income, such as wages. And if they have any remaining losses, they can carry them forward to use in future years.

You must actually sell an investment to realize the loss; paper losses don’t count. And the investments must be held in a taxable account, not a retirement account such as an IRA or a 401(k).

Timing matters

Capital gains and losses are classified as short-term or long-term, depending on how long you hold an investment before you sell it. If you hold it for one year or less, your capital gain or loss is short-term. If you hold it for more than a year, your capital gain or loss is long-term.

You match up your short-term losses against your short-term gains and your long-term losses against your long-term gains. Net short-term gains are taxed at your ordinary income-tax rate, which can be as high as 35%. Net long-term gains are taxed at lower capital-gains rates.

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For 2009, the maximum capital-gains rate for most people is 15%. Taxpayers in the two lowest income-tax brackets -- 10% and 15% -- pay 0% on their investment gains and qualified dividends. (Collectibles, such antiques, gems and precious metals, plus stamp and coin collections, are taxed at a special 28% capital-gains rate.) Capital gains and losses are reported on Schedule D.

Worthless stock

In some cases, it’s impossible to sell securities to claim a loss because the securities have become worthless. Taxpayers can claim the loss as having occurred on the last day of the year in which the securities lost all value. The key is that the security must truly have no value. The worthlessness has to be established by some identifiable event, such as a bankruptcy that totally wipes out shareholders’ value or by a company actually going out of business.

Sometimes, a company’s stock will still trade -- perhaps for pennies a share -- even following a bankruptcy, so it still has some value. In that case, your broker may help take the shares off your hands so you can write off the loss. Many brokers have special rules for buying nearly worthless stock from customers, charging a few dollars to buy the shares and giving you the necessary documentation you need to declare a loss.

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Help for Ponzi scheme victims

Some investors are left high and dry because their “investments” were never invested in the first place. The most notorious recent Ponzi scheme was run by Bernie Madoff, who was sentenced to prison in 2009 for running a wealth-management business that defrauded thousands of investors of billions of dollars. (In a classic Ponzi scheme, named after a man who perpetrated a gigantic fraud in the 1920s, investors are paid “earnings” out of the money that they, or new investors, have contributed, without any real profits having been realized.) More than 150 Ponzi schemes came to light in 2009.

Losses in fraudulent investment schemes receive special treatment under the tax laws. They are treated as theft losses, rather than ordinary investment losses, so they are not limited to offsetting only $3,000 of ordinary income. And they are not subject to the ordinary limitations on casualty and theft losses, which have a $500 floor in 2009 and are deductible only to the extent that they exceed 10% of adjusted gross income.
The amount of the loss equals the amount invested less any “profits” or “earnings” received and any recovery victims have made or are likely to make. The loss can also include any income taxes previously paid on “earnings.” Victims are allowed to claim the loss in the year in which they discover the fraud.